Federal regulators got a fresh inside look at Citigroup's books over the weekend -- and it wasn't pretty.

The result: a new $306 billion federal bailout for the bank. On the one hand, it provides more clarity as to the lengths the government will now go to shore up the U.S. financial system. On the other hand, investors continue to be wary about whether Citi was worth saving from oblivion. Worse, some of them worry that if a bank with one of the highest capital ratios nearly went under, who's next?

"You had a tremendous amount of people looking inside at Citi in the last few days to figure out how bad it was, and they came away thinking that the capital markets can't handle this," says David Ellison, manager of the $185 million FBR Small Cap Financial Fund. "So, Citigroup wasn't a going concern. What does it tell you about the industry and everybody else all around the world that has the same assets?"

On Monday, at least, the market chose to view the bright side of the Citi deal. Citi's shares jumped 2.18, or 58%, to close at 5.95 on Nov. 24. And the prospect of stability for financial stocks lifted the broader market, as the Dow Jones industrial average gained 397 points, or 4.9%, to 8,443.39. The Standard & Poor's 500-stock index gained 52 points, or 6.5%, to 851.78.

Bailout Terms

Citigroup agreed to the unprecedented series of steps with the U.S. Treasury, the Federal Reserve Board, and the Federal Deposit Insurance Corp. to strengthen the bank's capital ratios, reduce risk, and increase its liquidity. Under the program, announced on Nov. 24, the Treasury will invest an additional $20 billion in Citi preferred stock under the Troubled Asset Relief Program (TARP), on top of $25 billion the bank received about a month ago.

Also, Citi will issue an incremental $7 billion in preferred stock to both the Treasury and the FDIC as payment for a government guarantee on $306 billion of securities, loans, and commitments backed by residential and commercial real estate and other assets. The bailout agreement also means that Citi must submit any executive compensation plans to the government for approval.

Under the guarantee, Citi will assume any losses on the $306 billion portfolio up to $29 billion on a pretax basis -- meaning the government will assume 90% of any losses.

According to people familiar with the negotiations, the government struck a plan to "ring-fence" around about $300 billion in questionable assets, which will remain on Citigroup's books. That was the only group of assets for which the feds and Citi could agree on a potential value, sources say. That amounts to just 15% of Citi's total assets, which are a shade over $2 trillion.

The plan is not only good for the system, say those sources, but it provides cheap insurance for the government compared with the costs of a financial system in meltdown mode.

Sources also say that the calculations on the value of the portfolio were made on the "very unlikely event" that the U.S. economy has a downturn as severe as the Great Depression. The values of the assets in that $300 billion pool were based on projected cash flows for the life of the assets and not on their current and fluctuating distressed prices.

The Hit to Shareholders

In an internal memo sent out early Monday morning, Citi Chief Executive Officer Vikram Pandit said he appreciated how hard the speculation about Citi's fate had been on "clients, colleagues, business partners, and shareholders. Despite these challenges, all of you have distinguished yourselves in staying focused on serving clients and I am proud of your professionalism and hard work. Citi is America's bank around the world and our strength is viewed as an integral part of the overall strength of the U.S. financial system."

Pandit continued: "Tonight, we've taken an important step to dramatically reduce our future risk exposure and eliminate the lingering doubt in the market about Citi's financial strength.. . . This is an innovative, market-based solution that allows us to purchase insurance from the Fed to limit future risk."

While the arrangement helps Citi free up some $16 billion of capital, it comes at a cost to shareholders. Citi will issue warrants for approximately 254 million shares of its common stock at a strike price of $10.61. The dividend was also slashed to 1c for three years, effective on the next quarterly common-stock dividend payment. The terms of the deal with the government for an emergency cash infusion among other things require Citigroup to essentially borrow money from the federal government at 8%, and lend at the prevailing 4% market rate, says Ellison.

Citi's Precarious Health

There's only one reason to agree to such terms, says Ellison: to stay alive. "There are capitalists all over the place, but no one wanted to do the deal," he adds. "This is chemo. They need this capital to stay alive."

By one measure -- tangible common equity to tangible assets -- Citi already was on life support. The ratio is a strict definition of shareholder capital (setting aside infusions from TARP or the government) compared with the book value of a bank's assets. It's not a number that necessarily defines the overall financial health of a bank, but it's one gauge to measure capital adequacy. A bank that ranks low on this measure doesn't necessarily rank low on other measures. For Citi, that ratio is 2.4% vs. a more typical ratio for big banks of 5% to 6%.

That means a 1% decline in the value of Citi's assets, or $20 billion, would reduce common shareholders' equity by about 42%. Says Bill Mann, financial analyst for Motley Fool: "What's scary is that it wouldn't have taken much for the bank to be wiped clean."

More Bank Failures to Come?

If Citi was in dire need of government intervention, what about other big banks? Joel Cohen, co-CEO of Sagent Advisors, a financial advisory firm and former co-head of global mergers and acquisitions at Donaldson, Lufkin & Jenrette, isn't encouraged: "There's still a lot of this bad stuff on banks' balance sheets."

Indeed, late on Nov. 21, the FDIC brokered the sale of Downey Savings & Loan and PFF Bank & Trust to US Bancorp (USB). Those two banks were financially strapped and struggling under the weight of poor assets. That brought the number of failed banks in the U.S. to 22 so far this year. FDIC-insured commercial banks and savings institutions reported net income of $5.0 billion for the second quarter of 2008 -- the second-lowest quarterly total since 1991 and $31.8 billion, or 87%, less than what the industry earned in the second quarter of 2007.

Higher loan-loss provisions were the most significant factor in the industrywide earnings decline. Loss provisions totaled $50.2 billion, more than four times the $11.4 billion quarterly total of a year earlier. Almost one-fifth of FDIC banks were unprofitable in the second quarter, and that's before consumer spending plummeted in October.

In Citi's case, profits will be even harder to come by under the terms of its bailout. In exchange for the TARP money, Citi will have to pay the government $3.4 billion after tax, which equates to about 63� a share, or 7% of book value. "That's a meaningful drag on profitability," says Sean Ryan, a financial analyst with Sterne Agee.

More broadly, the government's action should set a more solid bottom on certain risky mortgage-backed assets. Mann says he hopes the bailout will calm fears brought on by federal regulators' seemingly willy-nilly decision-making about which banks survive and which don't. "I am hopeful that this bailout will be the cookie-cutter approach so that investors won't be wondering what the government is going to do next time," he says. "That's a big reason people's nerves have been so frayed; we need to have some expectation of what's going to happen."

Institutional Accountability

Whether it winds up being a good deal for taxpayers or shareholders, of course, is another question that may take a while to answer. Says Aite Group Research Director Christine Barry: "Additional funding for Citi will likely result in anger among consumers, not to mention the Pandora's box it will be opening for the government by setting a precedent that it will just keep printing money and handing it out to any big institution that needs it. At some point the handouts have to stop and institutions have to start to take some accountability for what happened."

In the end, the decision to save Citigroup was about rescuing the financial system from systemic crisis. Ellison says in general the market prefers "Adam Smith's calm hand, not Charles Darwin's punch in the face." But before he'll feel comfortable buying Citi shares, Ellison says he needs answers to some basic questions: How will the company put new capital to work? How much capital will they need next year? What's the plan to return the bank to profitability? How will new stock and bond issuance impact existing shareholders?

Indeed, some analysts and industry executives believe that once the sense of crisis passes Citi will still need to be broken up and management shown the exit. Says William Smith, senior portfolio manager with Smith Asset Management, a Citi shareholder: "There will be a revolt, sooner or later. It will be Pandit and [director and member of office of the chairman Robert] Rubin's heads on the platter. The question is. . . who will serve it up? The government, employees, or shareholders?"